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May 23, 2011

ABC of Fixed Income Investing - Types of Risks
Series on basics of investing in fixed income funds-Part V

by Niketa Agarwal

 ABC of Fixed Income Investing - Types of Risks

Retail investors in India can be said to be reasonably well informed when it comes to investments in equities, real estate or even assets like gold or silver. The Fixed Income asset class, however, is not so well known. As a tool for diversification, and as a safe avenue for volatile times, understanding this class is important. Even experts agree that greater retail participation in the fixed income market in India will make it more robust.

Fundsupermart.com has always tried to draw notice to this asset class through various research and personal finance articles on the website. Taking this initiative further, we bring to you this series explaining basics of fixed income investments!

A. INTRODUCTION TO THE FIXED INCOME ASSET CLASS>>

B. Understanding YIELD>>

C. SECURITIES THAT DEBT FUND MANAGERS INVEST IN>>

D. INTRODUCTION TO DEBT MUTUAL FUNDS>>

E. Types of Risks

Risk can be defined as the possibility of incurring a loss on an investment. An investment is deemed as risk if the returns are variable or may result in capital erosion.   
In this section, we elaborate on the different risks associated with debt funds.

Interest Rate Risk:

The fluctuation in the bond price due to movement in interest rates. As a rule of thumb, when interest rates go up, the value of a bond goes down.
We can illustrate this with an example:

Let us say, the interest rate stands at 4%. A bond with a coupon rate of 4% and face value of INR 1000 is likely to sell at par value. This is because a buyer of this bond will be indifferent to buying this bond and saving directly with a bank.

If the interest rate surges by 100 basis points (bps) to 5%, then bondholders with a 4% coupon rate are more likely sell the bond and keep the money with a bank account instead. This selling pressure will adjust bond prices downwards. Hence, at higher interest rates, bond prices will generally be lower.  

Similarly, if interest rates drop to 3%, the 4% bond coupon rate is more attractive and buyers will start purchasing this bond instead. The buying pressures will adjust the bond prices upwards. Hence, at lower interest rates, bond prices will generally be higher. 

Interest Rate Risk and Fixed Income Funds

Since a debt fund mainly consists of bonds as its underlying assets, the portfolio value of a debt mutual fund will also react in a similar manner to interest rate changes.  However, a debt mutual fund is diversified into fixed income securities of varying maturities and coupon rate. Hence, a debt fund is less subject to interest rate risk as compared to an individual bond.
 Typically, long-term fixed income securities are affected more than the short natured ones if the interest rates go up. This is because the holder of the bond will received lower coupon payments over an extended period of time as compared to the short term bond which can be easily reinvested at higher rates. Thus, investors should be cautious while investing in long-term debt funds such as GILT and Income funds in a rising interest rate scenario. On the contrary, the bond price for a long-term bond will go up, resulting in capital gain if the interest rates prevailing in the market fall.

Credit Risk:

The possibility of a bond issuer failing to repay the principal and interest in a timely manner is known as credit or default risk.  In India, there are few credit rating agencies that provide rating service for bonds. The credit rating agency evaluates the credit worthiness of a company or an individual considering a variety of factors like their assets, liabilities, past history etc.
A typical rating system is shown in the table below:


 Typical Credit Rating System

AAA

Highest Safety

AA

High Safety

A

Adequate Safety

BBB

Moderate Safety

BB

Inadequate Safety

B

High Risk

C

Substantial Risk

D

Default or Expected to Default

Credit Risk and Fixed Income Funds

The debt funds provide a breakdown of their portfolio holding regularly in the monthly factsheets. Typically, the fund should have minimal exposure to unrated securities. Sometimes, a particular fund generates exceptionally high returns over other funds belonging to the same category. It may be due to higher allocation to low rated papers. Hence, an investor can keep a tab of the credit portfolio of a fund while investing for safety and stability. 

Ratings Downgrade Risk:  

The risk that the bonds would be downgraded by credit rating agencies. It is also important for an investor to keep tab of the credit ratings issued by agencies as the returns are proportional to the current rating of the bond.

For Example:

A triple-A rated bond with a 6% coupon currently sells at INR1000. Some investors may invest in the bond because of its triple-A rating, considering the highest rating of safety.

The revised rating is triple-B, the risk-return ratio that was once attractive for current bondholders, will now become unattractive as the risk has increased without any increase in returns. Holders of this bond will sell the bond, causing downward pressure on the bond price.  

 

 

Ratings downgrade and Fixed Income Funds

A debt fund portfolio is exposed to this form of risk when the rating of the underlying bonds forming a large part of the portfolio is downgraded.  Downgrade risk can be offset partially by diversification.

Yield Curve Risk

The yield curve shows the relationship between the cost of borrowing and the maturity of the debt papers of equal credit quality. The expected yield of bonds of a particular credit quality is expected to follow the yield curve.

The risk here is depicted by the steepening or the flattening of the curve as a result of changing yield among comparable bonds with different maturities.

A yield curve representing India Government Bonds is  shown in the chart.

The duration where the curve becomes flattened (example: in red between the duration 3M-1Yr) the investor gets lower yields as the market rates fall and the investors go in for long term instruments in comparison to short term.

Similarly, in the case of the duration where the curve steepens (example: between 5Y -9Y)with high market rates the investors go in for shorter term instruments in comparison to long term ones which results in curve steepening.

Yield Curve Risk and Fixed Income Funds

The shifts in a yield curve risk define the way the debt fund portfolio reacts to market rate fluctuations. This reaction of the portfolio is indicative of the returns achieved by an investor on his portfolio. This happens as the shift in a yield curve, simultaneously causes a change in the bond priced which are in accordance with the former yield curve.
Therefore, with high market rates investors prefer shorter term debt instruments in comparison to long term. At the same time, the issuer would try to sell long term instruments before the increase in market rates. This results in an increase at the long end of the curve resulting in steepening the curve.
When the market rates are expected to fall investors prefer longer term instruments in order to safely lock in their money. Therefore, the price of longer term instruments rise eroding yields. Similarly, the issuer wants to sell shorter term instruments so that he has to pay the higher interest rates for a shorter duration. This results in a flattened yield curve.

Reinvestment Risk:   

The reinvestment risk applies to the risk of achieving lower returns on an investment than before. This risk is apparent more in the case of callable bonds. As the issuer can call these bonds back before maturity and it may happen that the reissued bond may not provide the same returns to the investor as the previous one.
This is more obvious in the case of bonds with lower credit rating. Therefore, it is necessary for an investor to check the credit rating of the bonds before purchasing it. At the same time, the callable bonds provide higher returns to an investor as a result of the reinvestment risk associated with them.

Reinvestment Risk and Fixed Income Funds

This happens when the debt fund has underlying bonds with varying maturities, coupon rates and yields. Whenever, the fund receives coupon payments or proceeds from maturing bonds, the manager looks for other similar alternatives to invest these proceeds. However, there lies a possibility that the fund manager is unable to find an attractive alternative that provides similar yields than the previous one.
The fixed income funds having a short term maturity are more prone to this risk. As in this case, the time horizon available to the fund manger to find an alternative is less. Similarly, bond funds carrying frequent coupon payments like on quarterly basis are also prone to this risk as the fund manager has to frequently look for alternatives. 

Conclusion

It is imperative for investors of debt funds to be aware of these risks as bond funds are exposed to these five main risks. An investor armed with this knowledge is capable to understand his investment and make better decisions in order to capitalise on the opportunities to obtain better returns.

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We would continue with the series. Watch this space for more...

 


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